OTC derivatives—A primer on market infrastructure
and regulatory policy
Ivana Ruffini and Robert S. Steigerwald
Introduction and summary
Derivatives have long been important tools for manag-
ing risk. In particular, as Culp (2004) explains, “deriva-
tives can be used as a means of engaging in risk transfer,
or the shifting of risk to another firm from the firm whose
business creates a natural exposure to that risk” (p. xiv).
In this article, we discuss some recent developments
relating to the regulation of derivatives markets, spe-
cifically the Group of Twenty (G-20) mandates, and
examine the infrastructure that supports derivatives
markets (including both the trade execution and post-
trade clearing and settlement processes). Then we
identify some of the policy issues raised by the G-20
market structure mandates. To provide a foundation
for that discussion, first we explain some key concepts
and terms.
Key concepts and terms
What is a derivative? A derivative is a financial
contract whose value is based on an underlying market
factor, for example, a reference rate or index, commodi-
ty, or other asset that is used to manage risk or support
a particular profit-maximizing strategy.
How are derivatives traded? Derivatives contracts
may be traded over-the-counter (OTC), through swap
execution arrangements (developed in response to post-
crisis legislation), or in listed markets on exchanges.
OTC markets are characterized by the absence of a cen-
tralized trading mechanism and dependence on dealers
as liquidity providers. By contrast, listed markets typi-
cally use a central limit order book to aggregate the
trading interests of buyers and sellers. This permits
participants in listed markets to trade with each other in
an auction environment. OTC and listed markets, how-
ever, “do not represent a black-and-white dichotomy,”
but points along a continuum of trade execution arrange-
ments (Culp, 2009, p. 5). Technological advances have
enabled the creation of a variety of electronic platforms
80
for trading standardized OTC products, some of which
seem “very close to the central limit order book oper-
ated on exchanges.”1
How are the terms of derivatives contracts deter-
mined? Bilaterally negotiated and customized derivatives
contracts are hallmarks of OTC derivatives markets.
These contracts are negotiated between counterparties
(typically, a pair of dealers or a dealer and a client) and
are tailored to meet the counterparties’ specific needs
and risk appetite. Some market participants may not
require customized contracts. They may instead trade
Ivana Ruffini is a senior policy specialist and Robert S. Steigerwald
is a senior policy advisor in the financial markets group of the
Economic Research Department at the Federal Reserve Bank
of Chicago. The authors thank Ed Nosal, Lisa Barrow, Richard
Heckinger, Kirstin Wells, and David Marshall for helpful com-
ments and conversations.
© 2014 Federal Reserve Bank of Chicago
Economic Perspectives is published by the Economic Research
Department of the Federal Reserve Bank of Chicago. The views
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of the Federal Reserve Bank of Chicago or the Federal Reserve
System.
Charles L. Evans, President; Daniel G. Sullivan, Executive Vice
President and Director of Research; Spencer Krane, Senior Vice
President and Economic Advisor; David Marshall, Senior Vice
President, financial markets group; Daniel Aaronson, Vice President,
microeconomic policy research; Jonas D. M. Fisher, Vice President,
macroeconomic policy research; Richard Heckinger, Vice President,
markets team; Anna L. Paulson, Vice President, finance team;
William A. Testa, Vice President, regional programs; Lisa Barrow,
Economics Editor; Helen Koshy and Han Y. Choi, Editors; Rita
Molloy and Julia Baker, Production Editors; Sheila A. Mangler,
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ISSN 0164-0682
3Q/2014, Economic Perspectives
 FIGURE 1
Bilateral and centrally cleared networks
A. Bilateral clearing
End-user Small financial institution
Source: Council of Financial Regulators, 2011.
derivatives contracts that have standardized (vanilla)
terms. Standardized contracts do not involve negotia-
tion of terms other than price and quantity.
What is clearing and settlement? The term clear-
ing generally refers to a series of operational and risk
management processes that occur after a trade is exe-
cuted and before the contract is settled. Settlement
involves the completion of all payments or transfers
(for example, of commodities or securities) in accor-
dance with the contract’s terms. Settlement discharges
the counterparties from their legal obligations under
the contract. “Central counterparty clearing” refers to
an arrangement by which a central counterparty (or
CCP) is substituted as a principal to all cleared trades,
becoming the buyer to all sellers and the seller to all
buyers (CPSS–IOSCO, 2012, p. 9). As a result of coun-
terparty substitution, the bilateral contract between the
original buyer and seller is irrevocably terminated.
Figure 1 provides a stylized depiction of the struc-
ture of counterparty relationships in bilateral and cen-
trally cleared markets. The left panel of figure 1 illustrates
a network of bilateral counterparty relationships be-
tween pairs of market participants. Some participants,
in particular, all of the large financial institutions at the
core of the market (in blue), have bilateral counterparty
relationships with each other. Others, such as smaller
financial institutions and end-users (in gray and peach),
may trade with only one or two counterparties. There
is no central node in this market structure, and counter-
party risk is distributed through the network.
Federal Reserve Bank of Chicago
b. Central clearing
CCP
Large financial institution
In the right panel of figure 1, a clearinghouse has
been substituted as the common counterparty to all
clearing members (in this illustration, only the large
financial institutions are direct clearing members of
the CCP). Bilateral contracts between clearing members
are terminated and replaced by contracts between each
clearing member and the CCP. Bilateral contracts be-
tween clearing members and their non-clearing member
counterparties (that is, the smaller financial institutions
and end-users) remain in effect. In this market structure,
counterparty risk is aggregated in a central node, the CCP.
As we discuss later in this article, this centralization
of risk can be both beneficial and a source of fragility.
The new regulatory environment
The Global Financial Crisis, generally acknowl-
edged as the worst financial meltdown since the Great
Depression, crippled housing, credit, and equities markets
and highlighted the extent of interconnectedness among
market participants, now widely recognized as a source
of systemic fragility. In particular, some participants
in OTC derivatives markets came under stress and
one, AIG, required government intervention.
The heads of state of some of the world’s largest
economies met in Pittsburgh in September 2009 to
discuss ways to strengthen the international financial
regulatory system. The Group of Twenty (G-20) summit
resulted in agreement on a broad program of regulatory
reform, including fundamental changes to the regula-
tion of OTC derivatives markets. In particular, the G-20
reform program provides that, “where appropriate,”
81
trades involving standardized OTC derivatives must be
executed on exchanges or electronic trading platforms
and cleared through CCPs.2 It also imposes higher
capital requirements for non-centrally cleared trades
and the reporting of all OTC derivatives trades to trade
repositories.3 The G-20 assigned the responsibility to
monitor and assess the implementation of these reforms
to the Financial Stability Board (FSB).4
Later in this article, we consider some of the policy
issues raised by the G-20 market structure mandates.
In particular, we note that there are divergent opinions
concerning the costs and benefits of mandatory exchange
trading and central clearing of derivatives. Further
analysis is needed before one can conclude that the
benefits of centralized trading and clearing of deriva-
tives outweigh the associated costs.
Market infrastructure
OTC derivatives are contracts, and assessing the
size of the OTC derivatives market can be challenging
because of the variability of contract terms. The in-
dustry generally uses the notional amount outstanding
to track the size of the OTC market. The term “notional”
refers to the principal or face amount used to calculate
the payment or settlement obligations defined in the
derivative contract. However, the notional (or principal)
amount is not typically exchanged between counter-
parties and, therefore, is not at risk. For example, take
a fixed for floating interest rate swap (IRS) on a $1
million notional amount—the only amount that would
change hands each period would be the net interest
payment calculated on the notional amount. This means
that if the fixed rate were 5 percent and the floating
rate 4 percent for the period of one year, the amount
of money at risk would only be $10,000—the amount
that the payor of the fixed rate would have to pay its
counterparty (see appendix C). There are exceptions—
some types of OTC derivatives, such as credit default
swaps (CDS) and some foreign exchange (FX) swaps
may, but don’t necessarily involve the exchange of
full notional amounts.
In December 2013, the average notional amount
outstanding of OTC derivatives was $710 trillion, more
than eight times the average notional amount outstand-
ing in June of 1999 of about $81 trillion (figure 2).
Representing markets in terms of notional amounts has
limitations. For example, it may foster misunderstand-
ing about risks associated with particular derivative

FIGURE 2
OTC derivatives market, notional amounts outstanding ($trillions)
800

700

600

500

400

300

200

100

0
Jun. Jun. Jun. Jun. Jun. Jun. Jun. Jun. Jun. Jun. Jun. Jun. Jun. Jun. Jun.
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Unallocated Interest rate swaps

Credit default swaps Foreign exchange
Commodity Exchange-traded contracts
Equity-linked

Source: Authors’ calculations based on data from the Bank for International Settlements.

82 3Q/2014, Economic Perspectives

instruments. For example, in figure 2 interest rate swaps
have the largest notional amounts, but this does not
mean they carry the most risk. In reality, the risk ex-
posure from a particular type of OTC derivatives contract
depends on various factors, such as the concentration
of positions and the volatility of the underlying asset.
Notional amount is just one of a number of inputs
used to calculate risk exposure.
Since the crisis, total average notional amounts
have tended to be in a range between roughly $600
and $700 trillion. According to some commentators,
this leveling off is mostly a result of an increase in
trade (portfolio) compression and a post-trade risk
management process that reduces notional amounts
though the elimination of redundant positions (posi-
tions that offset each other and thus have no economic
value) (Kaya, 2013).
Economically redundant positions can occur when
market participants change their trading strategies. For
example, one of the counterparties to a non-cleared
IRS may want to change or eliminate the interest rate
exposure from that contract. That can be accom-
plished either by terminating or renegotiating the
terms of the existing contract. However, termination
or renegotiation of an existing contract requires the
agreement of the other counterparty, which may not be
feasible. For example, the other counterparty may
want to maintain the original risk exposure, or may be
willing to terminate only at a premium over prevail-
ing market rates (Steigerwald, 2014).
It may be simpler and more economical to enter into
an offsetting swap with a new counterparty. By enter-
ing into a new IRS with matching (but opposite) cash
flows, the market participant that has changed its trading
strategy can eliminate the economic risk of the original
position (PIMCO, 2008). The redundant IRS positions
eliminate interest rate risk, but not the credit risk that
one of the counterparties may fail to perform its obliga-
tion. The Lehman Brothers insolvency in mid-September
2008 brought to light the magnitude of redundant de-
rivatives positions (called “notional overhang”) and
prompted efforts to reduce it through multilateral ter-
minations of such contracts (Kiff et al., 2009).
The Bank for International Settlements (BIS)
calculates the gross market value of the OTC market
by aggregating the market values of all outstanding
in-the-money contracts before netting. Approximately
4 percent of gross notional value has been considered
by the industry to be a good estimate of the gross mar-
ket value of OTC derivatives. For example, as of June
2012, the average notional value outstanding was
$638.9 trillion, while the gross market value amounted
to $25.4 trillion, or 3.97 percent of notional value
Federal Reserve Bank of Chicago
(International Swaps and Derivatives Association
[ISDA], 2012).
OTC derivatives markets and infrastructure5
Bilateral negotiation of contract terms is one of
the defining features of the OTC derivatives market.
Recent changes prompted by the G-20 regulatory re-
forms for derivatives markets are intended to trans-
form the traditional structure of these markets. In this
section, we provide a foundation for understanding
this transformation by examining the characteristics
of different derivatives instruments, the various ways
derivatives are used by market participants, and the
importance of counterparty credit risk in shaping
post-trade clearing and settlement arrangements.
Derivatives instruments
Derivatives are risk transference contracts whose
value is based on one or more underlying market factors
(Office of the Comptroller of the Currency, n.d.)—
such as events (for example, defaults and bankruptcies),
reference rates (for example, interest rates and foreign
exchange rates), and the prices of assets, (such as
commodities, bonds, and equities). Derivatives instru-
ments include forwards, futures, swaps, and options
(see the appendices for detailed examples).
Forwards are bilateral contracts that specify the
terms of an exchange at a future date (McDonald, 2012).
Forwards typically have no upfront costs or fees, making
it possible for market participants to enter positions
without incurring immediate costs.
Futures are standardized forward contracts that
are traded on exchanges and centrally cleared by CCPs
(McDonald, 2012). Futures contracts, like forward
contracts, call for an exchange at a future date, but
the terms of the contract (other than price and quantity)
are established as standard terms for all traders by the
exchange. We discuss central counterparty clearing
and counterparty credit risk in more detail later.
Swaps are derivatives contracts that set out the
terms of a series of forward transactions (McDonald,
2012). Typically, a swap transaction involves an ex-
change of cash flows based on the notional amount at
specified intervals (or “reset” dates) during the life of
the swap. Some swaps, however, call for an exchange
or payment of the full notional amount. Generally, swaps
are structured so that at inception, the value of the
swap is zero. Swaps may be traded and cleared either
bilaterally or through central market infrastructures.
Options6 are derivatives contracts that give the
holder of the contract the right but not the obligation
to purchase or sell the underlying interest at a specific
date or time interval in accordance with the terms of
83
the contract (U.S. Securities and Exchange Commission,
2004). The buyer of an option pays a premium for the
right to exercise the option (by buying or selling the
underlying interest) in the future. The seller of an option
receives the premium in return for agreeing to buy or
sell the underlying interest to the option holder at the
agreed price if the holder exercises the option. Options
are traded both in listed markets and over-the-counter.7
Market participants
Derivatives can be used by market participants to
achieve a desired risk exposure, to speculate in the
markets, to reduce transaction costs, or to avoid certain
regulatory costs (McDonald, 2012). Market participants
can be classified as hedgers, speculators, or a combi-
nation of the two.
Hedgers seek to transfer or manage risk exposures.
For example, an airline may wish to lock in the price
of fuel over a certain time horizon so that it can accu-
rately forecast its cost basis and offer airline tickets for
sale months in advance. It may do so by hedging in the
energy derivatives market. There are limited opportu-
nities to hedge jet fuel using jet fuel futures. Airlines
may hedge with a mix of crude oil, heating oil, and
unleaded gasoline futures calibrated to closely corre-
late with the volatility in the jet fuel prices or use cus-
tomized swaps. Similarly, banks and other end-users
that are exposed to maturity, currency, and interest
rate mismatches between assets and liabilities may
enter into swap agreements to balance their exposure
(Miller, 1998).
Hedgers may be exposed to basis risk if the hedge
position does not exactly correspond to the underlying
risk exposure. Basis risk is a broad term that describes
a risk exposure resulting from an imperfect hedge. This
exposure can be exacerbated by differences in the
terms of the hedge contract and the underlying risk
position, such as differences in expiration, maturity,
and other material dates; delivery terms (for example,
location, transportation, and storage costs); and changes
in yield curves.
Speculators enter into derivatives contracts purely
seeking profit. Some speculators benefit from the lever-
age that is associated with derivatives contracts—as a
result, the profit or loss can be large in comparison to
the initial cost of entering into a trade. Others may
benefit from lower transaction costs or from regulatory
or tax arbitrage. For example, taxes on the sale of
stock can be deferred when derivatives are used “to
achieve the economic sale of stock (receive cash and
eliminate the risk of holding the stock) while still main-
taining physical possession of the stock” (McDonald,
2012, pp. 2–3). Speculators are important because
84
they contribute to market liquidity. Hedgers benefit
from this liquidity. In practice, the line between the
hedgers and speculators can be blurred, as some market
participants may alternate between taking speculative
positions and hedging risk.8
Counterparty credit risk
There are many risks associated with derivatives
trading. We focus on counterparty credit risk because
it plays a key role in shaping post-trade clearing and
settlement arrangements for derivatives markets.
Market participants that enter into a derivatives
contract are exposed to the risk that the counterparty
may default before the contract matures. This exposure
is commonly referred to as counterparty credit risk.
Counterparties may be required to pledge cash or
securities as collateral (sometimes called margin) to
mitigate this counterparty credit risk.9 Assessing poten-
tial loss exposure given the possibility of counterparty
default (commonly referred to as loss given default)
is complicated. For example, the value of an interest
rate swap at inception is usually zero for both parties.
As the underlying rates, asset prices, and other condi-
tions outlined in the swap agreement change, the swap
valuation also changes. The contract becomes “in the
money” for the party that is due a payment, and “out
of the money” for the party that owes a payment. These
periodic payments are calculated on notional amount.
A credit loss on an IRS would occur if at the time of
counterparty default the swap is in the money for the
non-defaulter. Thus, the amount at risk of an in-the-
money position is the in-the-money amount, not the
notional amount.
Assessing loss given default for a credit default
swap (CDS) is even more complex. A CDS buyer seeks
protection from losses that may be caused by default
of a specified reference credit (for example, a company,
a security, or a reference entity in an index10). The
protection buyer pays periodic premiums to the seller,
who in turn agrees to make a payment up to the notional
amount to compensate the buyer for losses resulting
from specified credit events. Credit events are speci-
fied in the CDS contract and can vary from bankruptcy
to obligation acceleration (when a bank declares a debt
due before maturity).
CDS are settled either by payment of cash differ-
ences or delivery of the underlying reference interest.
In cash-settled contracts, the reimbursement for the loss
is calculated as the difference between the notional
and the post-credit-event value of the underlying refer-
ence credit. In physically settled contracts, the buyer
delivers the actual obligation of the reference entity
(for example, a bond or other security) and the seller
3Q/2014, Economic Perspectives
pays the face amount of the obligation. Paradoxically,
physical delivery can trigger demand for the underly-
ing bonds covered by CDS contracts, causing the price
of the bond to increase. In 2009 the International Swaps
and Derivatives Association (ISDA) established new
settlement procedures for CDS. Under those procedures,
a committee of industry experts will decide whether a
credit event has occurred and whether or not to con-
duct an auction to determine the cash settlement price
(ISDA, n.d.).
Market infrastructure
Financial markets have evolved in a variety of
ways—in particular, developments in computing, data
processing, and communications technologies have
had a transformative impact. In this section, we briefly
describe both the infrastructure for conducting derivatives
trades and the post-trade clearing and settlement in-
frastructure for derivatives markets, noting the effects
of recent changes in these structures.
Trade execution
In order to trade, traders first need to communicate
(either directly or through a third party) the desired
quantity, type of contract, and the price at which they
are willing to trade, as well as other material terms
and conditions. The second step includes recording
the details of the trade—contract terms and counter-
party identity. These first two steps are often referred
to as trade execution.
Organized exchanges and alternative trading
systems are different types of trading venues—they
differ in terms of how they perform their functions
and regulation (SEC, 1998). As a result of technological
developments, changes in regulation, and demutual-
ization, trading has transitioned away from pits and
telephones to electronic platforms. Today, the difference
between the two types of trading systems hinges on
the formality of the structure (with exchanges being
more formal) and the degree of regulatory oversight
(Kohn, 2004).
An exchange, for purposes of this primer, is an
organized and regulated marketplace for trading cer-
tain listed commodities, securities, or other financial
products and contracts. Exchanges create and list con-
tracts with standardized terms, such as expiration dates,
minimum price quotation increments, deliverable
grade of the underlying, delivery location, and mech-
anism. Not every financial contract can be traded on
an exchange. Typically, to be traded on an exchange,
a certain level of demand is necessary to ensure liquid-
ity (although some financial instruments that are stan-
dardized and trade in liquid markets, such as the U.S.
Treasury market, are not listed on exchanges). Exchanges
Federal Reserve Bank of Chicago
aim to ensure orderly trading and facilitate price dis-
covery. Examples of stock exchanges include the New
York Stock Exchange (NYSE), National Association
of Securities Dealers Automated Quotation System
(NASDAQ), and Tokyo Stock Exchange. Derivatives
exchanges include ICE Futures U.S., ICE Futures
Europe, Chicago Board Options Exchange (CBOE),
London International Financial Futures and Options
Exchange (LIFFE), Chicago Mercantile Exchange
(CME), and London Metal Exchange.
Alternative trading systems (ATS) are over-the-
counter trade execution venues. Initially, OTC con-
tracts were negotiated over the phone, but in the late
1990s alternative trading systems, or electronic platforms,
which functioned like bulletin boards for posting bids
and offers, began to emerge. More recently, electronic
platforms for trading swaps have been developed in
response to legislation implementing the G-20 trade
execution mandate. Bloomberg, Tradeweb, ICAP,
Tradition, and Tullett Prebon, among others, have
developed such swap execution facilities (SEFs).11
The implementation of these new swap trading
platforms has influenced the fragmentation of global
OTC derivatives markets (Giancarlo, 2014). This is
reflected in figure 3 (p. 88), which shows changes in
dealer trading activity after the implementation of the
G-20 trade execution mandate for swaps regulated by
the CFTC. This development has important implications
for financial stability. As CFTC Commissioner J.
Christopher Giancarlo recently noted, “[r]ather than
controlling systemic risk, the fragmentation of global
swaps markets into regional ones is increasing risk.”12
Figure 3 illustrates fragmentation in the global
swaps market. We see that as of October 2013, follow-
ing the implementation of the SEF mandate, trading
between European and U.S. dealers (the red line) dropped
from above 600 billion euros to a 200–300 billion
euro range. At the same time, trading between Euro-
pean dealers (the blue line) increased from 1.6 trillion
euros to 2.75 trillion in October. This trend continued
with the CFTC’s made-available-to-trade (MAT) de-
terminations, which expanded the number of deriva-
tives contracts available for trading on SEFs.
Throughout this period, we see a general decline in bi-
lateral trading between U.S. dealers (the green line)
following the implementation of the SEF trading re-
quirement, the expected consequence of the G-20 trade
execution mandate. We also observe geographical
fragmentation as evidenced in a decline in trading be-
tween European and U.S. dealers (the red line), ap-
parently reflecting the preference of European dealers
for trading outside of the SEF regime.13
85
Clearing and settlement
The next step in the value chain of a derivatives
transaction is clearing—generally including trade
matching and risk management (credit limits, margin
collateral requirements, etc.). Bilateral clearing can
be accomplished either directly between counterpar-
ties or through a clearing agent that matches records
and reports back to the traders. Alternatively, trades
can be submitted to a central clearinghouse, which
becomes the counterparty to both sides of the trade
and guarantees performance of the contract. The final
step is the settlement of the contract, whereby the
parties fully perform their respective obligations.
A specialized form of financial market infrastruc-
ture, the central counterparty clearinghouse or CCP, is
widely used in modern securities and risk transfer mar-
kets. The defining characteristic of central counterparty
clearing is counterparty substitution by means of no-
vation or an equivalent legal mechanism (Steigerwald,
2014). As a result of counterparty substitution, the clear-
inghouse becomes a principal to all trades it accepts for
clearing and the clearinghouse undertakes to perform
in place of the original counterparties to such trades.
The interposition of a clearinghouse as the common
counterparty to all trades accepted for clearing tends
to simplify and improve transparency of the bilateral
“credit chains” that may develop in repeated transac-
tions among market participants (Acharya, 2013).
Examples of central counterparty clearinghouses
include CME Clearing, Eurex Clearing A.G., ICE
Clear Credit LLC, The Options Clearing Corporation,
and LCH.Clearnet LLC.
G-20 policy discussion
In September 2009 the G-20 leaders agreed that
all “standardized OTC derivative contracts should be
traded on exchanges or electronic trading platforms,
where appropriate, and cleared through central coun-
terparties” (G-20, 2009, p. 9). They also agreed to impose
higher capital requirements for non-centrally cleared
trades and require trade data to be reported to trade
repositories. Although these are important aspects of
the G-20 regulatory reforms, we address the trade re-
porting requirement only incidentally in this article.
Both supporters and opponents of the G-20 man-
dates generally recognize the benefits of exchange trading
and central clearing. Nevertheless, they reach dramat-
ically different conclusions concerning whether these
changes will improve transparency in the derivatives
markets and mitigate systemic risks, as intended by
the G-20. In this part of the primer, we consider some
of these policy issues.
86
BOX 1
Who trades in OTC derivatives and why?
OTC markets meet a need for customized contract
terms for hedging purposes. For a hedge to qualify
for hedge accounting treatment, it needs to be suf-
ficiently correlated to the underlying interest, which
sometimes requires tailoring of contract terms.
Other benefits of OTC trading include liquidity in
a broader range of instruments than in listed mar-
kets and the ability to negotiate the placement of
large contracts on mutually favorable terms.
The OTC market includes the end-user (re-
tail) and interdealer (wholesale) segments. Most
end-users are hedge funds, corporations, asset man-
agers, and institutional investors, while dealers are
large banks. In the retail segment, dealer banks help
their clients create effective hedges; while in the
interdealer segment banks hedge their own aggre-
gated risk exposure across different lines of business.
Note: The Financial Accounting Standards Board (FASB)
has established standards known as Generally Accepted
Accounting Principles (GAAP), which include accounting
and reporting standards for derivatives.
Transparency and interconnectedness
in OTC derivatives markets
One of the main criticisms of OTC derivatives
markets is that they are not transparent. For example,
as Mengle (2009, p. 1) notes:
Characterizations [of OTC derivatives markets]
such as “murky,” “opaque,” and “anonymous”
appear regularly in the financial press. The
apparent implication is that financial markets
would be more efficient, and society would
be better off, if over-the-counter derivatives
moved to a higher level of transparency.
What does transparency mean in this context and
why does it matter? To answer that question, we draw
on the market microstructure literature,14 which defines
transparency as the quantity and quality of information
about trading that is available to market participants
and others. Madhavan (2000, p. 224) explains that:
Non-transparent markets provide little in the
way of indicated prices or quotes, while highly
transparent markets often provide a great deal
of relevant information before (quotes, depths,
etc.) and after (actual prices, volumes, etc.)
trade occurs.
The degree of transparency in a market depends
on many factors, such as the speed with which infor-
mation is disseminated and the extent to which it is
3Q/2014, Economic Perspectives
available to potential traders. One of the most impor-
tant factors, of course, is the means by which trades
are executed.
Auction markets typically use a centralized trading
mechanism, such as a central (or consolidated) limit
order book, which permits buyers and sellers to trade
with each other directly, without intermediation by
dealers (Harris, 2003). By comparison, OTC markets
are primarily dealer markets. As Duffie (2012) explains,
OTC markets do not “use a centralized trading mech-
anism, such as an auction, specialist, or limit-order book,
to aggregate bids and offers and to allocate trades”
(Duffie, 2012, p. 1).15 This has obvious implications
for the transparency of OTC markets, because “buyers
and sellers negotiate terms privately, often in ignorance
of the prices currently available from other potential
counterparties and with limited knowledge of trades
recently negotiated elsewhere in the market” (Duffie,
2012, p. 1). This, in turn, has obvious implications for
market efficiency and price discovery.
This absence of a centralized trading mechanism
means that buyers and sellers in OTC markets interact
through dealers rather than in an auction environment.
It also means that there is no single, central point for
aggregating and disseminating information about trades
that take place in the market. This may suggest that
centralized auction markets are inherently superior to
dealer markets. However, some markets do not have
sufficient trader participation to operate as continuous
auction markets.16 Consequently, many markets are
hybrids that use both centralized and decentralized
trade execution mechanisms.
Another important issue that is sometimes treated
as an informational problem—and, thus, an issue of
transparency—is the ability of market participants to
evaluate the creditworthiness of their potential coun-
terparties. Specifically, as Acharya and Bisin (2010,
p. 3) explain:
An important risk that needs to be evaluated
at the time of financial contracting is the risk
that a counterparty will not fulfill its future
obligations. This counterparty risk is difficult
to evaluate because the exposure of the coun-
terparty to various risks is generally not public
information.
This is, of course, a fundamental problem of finan-
cial contracting—namely, the ability of market partici-
pants to make credible commitments to carry out their
obligations at some time in the future, a problem that
arises even in direct, bilateral transactions between a
pair of counterparties (Nosal and Steigerwald, 2010).
Acharya and Bisin focus on the problem of commitment
Federal Reserve Bank of Chicago
BOX 2
Order-driven versus quote-driven markets
Derivatives trading may take place in “order-driven,”
“quote-driven,” or “hybrid” trading environments.
In an order-driven market, the willingness of a
market participant to trade a specified amount at
a specified or “limit” price is displayed to all other
market participants in a central limit order book.
Market participants may also submit “market” orders
to trade immediately at the current prevailing price.
By disseminating information about bids and offers,
order-driven markets enhance pre-trade transpar-
ency but do not guarantee that limit orders will be
executed (Kaniel and Liu, 2006; Macey and
O’Hara, 1997). A trade in an order-driven market
only takes place when an order to buy can be
matched against an order to sell in the central
limit order book.
A quote-driven (dealer) market does not use
a central limit order book. Instead, dealers in these
markets quote the prices at which they are willing
to enter into trades with others. These quotes may
only be indicative—that is, not binding as an of-
fer to enter into a trade on the quoted terms—and
may not be widely disseminated. Thus, pre-trade
transparency in dealer markets may be limited. In
contrast to order-driven markets, however, the ex-
ecution of a trade in a quote-driven market is not
dependent on the willingness of third parties to
buy or sell at limit prices that are widely dissemi-
nated. The buyer and seller in a quote-driven market
determine whether a trade will take place through
direct negotiations. As a result, traders in quote-
driven markets are assured of trade execution,
assuming they can reach agreement on the terms
of a trade.
in situations where traders are indirectly linked in
opaque “credit chains.” As Acharya (2013, p. 83)
explains:
[S]uppose that counterparty A agrees to pay
B. Then, A turns around and sells a similar
contract to C. The addition to A’s position
from the contract with C dilutes the payoff
on its contract with B in case that A turns out
ex-post to not have adequate funds to repay
both B and C. Thus, B’s payoff dependency
on what else A does represents a negative
payoff externality on B due to A’s counterparty
risk. The key efficiency question is whether
B can adequately reflect this risk in charging
price or adopting risk controls (e.g., margins
87
 FIGURE 3
Monthly interdealer cleared euro interest swap activity
(notional volume, euros in billions)

Post-Oct. 2, 2013 Post-Feb. 15, 2014

SEF Implementation MAT Implementation
3,000 900

800
2,500
700

European- and U.S.-to-U.S. Dealer

European-to-European dealer

2,000 600

500
1,500
400

1,000 300

200
500
100

0 0
Jan. Feb. Mar. Apr. May Jun. Jul. Aug. Sept. Oct. Nov. Dec. Jan. Feb. Mar. Apr. May
2013 2013 2013 2013 2013 2013 2013 2013 2013 2013 2013 2013 2014 2014 2014 2014 2014

European dealer to U.S. dealer

U.S. dealer to U.S. dealer
European dealer to European dealer

Notes: The figure refers to the CFTC’s implementation of the new trading requirements from October 2013 through early 2014.
SEF indicates swap execution facility, as defined by the Dodd–Frank Act and CFTC rules; MAT indicates made available for
trading (as determined by the CFTC).
Source: ISDA (2014).

or overall position limits) on A. Clearly, B’s it is dependent, even if only indirectly. Unlike pre-trade
ability to do so depends upon whether B can and post-trade transparency, however, this has nothing
observe what A does. to do with the availability of information about the
The inability of a direct counterparty to fulfill its prices and cannot be addressed by centralized trade
obligations, as a result of bankruptcy or other circum- execution. Instead, this externality must be dealt with
stances, may disrupt the performance expectations of by enhancing trader commitment in some fashion. This
others in the credit chain. Market participants are thus is the classic role of post-trade clearing institutions.
dependent upon the ability and willingness to perform We turn next to the trade execution and central
of a party with whom they did not deal directly and clearing mandates to consider their implications for trans-
whose creditworthiness they may not be able to evaluate. parency and interdependency in derivatives markets.
Acharya and Bisin (2010) call this form of interdepen- The trade execution mandate
dency a “counterparty credit risk externality.” The primary justification for the trade execution
This externality has an obvious informational mandate is that it “… can potentially increase trade
component—namely, that traders only know and can transparency, particularly pre-trade transparency, and
assess (however imperfectly) the creditworthiness of ... provide trade transparency more efficiently than
their direct counterparties. No market participant has OTC markets” (IOSCO, 2011, p. 35). Centralized
a complete view of the credit relationships upon which

88 3Q/2014, Economic Perspectives

auction-style trade execution mechanisms undoubtedly
enhance pre-trade and may also facilitate post-trade
transparency. But the benefits of centralized trading struc-
tures do not come without costs—including, potentially,
reduced liquidity, and impaired price discovery (Pirrong,
2010). Decisions about how much and what types of
information to make available to traders and how broadly
to disseminate that information have different impli-
cations for different types of market participant and
“... are likely to benefit one group of traders at the ex-
pense of others” (Madhavan, 2000, p. 241). For example,
traders who have private information tend to favor
anonymous trading systems, while others may favor
greater pre-trade transparency (Madhavan, 2000). These
decisions are critical to the design of trade execution
mechanisms. As Lee (1998, p. 98) explains:
The choice by an exchange of what price and
quote information to release is a central ele-
ment of the wider decision as to what market
architecture to adopt. Not only are there sub-
stantial differences between the types of data
about prices and quotes that trading systems
choose to release, there are also differences in
the types of information that trading systems
are able to deliver.
These differences in pre-trade transparency exist
because “... no single market structure is viewed as
best by all parties” (Madhavan, 2000, p. 251).
This point is supported by the market microstructure
literature, which conceives of the interaction between
investors and market markers as a strategic interaction
among parties with differences in risk aversion, capital
endowments, demand for immediacy, private infor-
mation, access to other trading alternatives, and so
on (for example, Duffie, 2012; Duffie, Gârleanu, and
Pedersen, 2005). Pre-trade transparency concerning
the prices and quantities at which market participants
are willing to enter into trades is important because
“... it affects the informativeness of the order flow
and hence the process of price discovery” (Madhavan,
2000, p. 241). As Duffie (2012, p. 5) explains,
“... dealers have incentives to narrow their bid–ask
spreads ... to compete for trading opportunities”
in markets that provide for enhanced pre-trade and
post-trade transparency. These benefits, however,
are not linear:
If price transparency is too great, ... some
dealers may lose the incentive to intermediate,
given their fixed costs and the risk of adverse
selection by informed customers. Unless the
potential demand ... is sufficient to justify ex-
change trading, a ... large increase in OTC
Federal Reserve Bank of Chicago
market transparency could ... potentially
reduce trading opportunities for investors.
(Duffie, 2012, p. 5)
In fact, “[a]nonymous exchange-based trading can
... lead to inefficiently thin markets or even market
failure” (Duffie, 2012, p. 8, emphasis added). The idea
that there can be too much transparency, however, is
completely absent from the arguments that are typically
made in support of the G-20 trade execution mandate.
Moreover, customized derivatives transactions are
valuable risk-management tools that facilitate hedging
and other trading strategies. This has important impli-
cations for risk management because remaining un-
hedged can be costly. For example, an enterprise that
is unable to enter into effective hedging transactions:
.. may choose to avoid some projects whose
uncertain cash flows have a high net present
value for their shareholders out of fear that
losses resulting from unhedged risks could
be misperceived by their shareholders or su-
periors as a reflection of poor project selection
or management. A failure to hedge can also
increase the probability of bankruptcy, or at
least financial distress, which brings additional
costs, such as legal fees or high frictional costs
for raising new capital when distressed. (Duffie,
Li, and Lubke, 2010, p. 10)
Accordingly, the Squam Lake Group suggests that
the benefits of centralized trading “should be weighed
against the benefits of innovation and customization
that are typical of the OTC market” (French et al.,
2010, pp. 70–71).
The G-20 apparently recognizes that the benefits
of the trade execution mandate may depend on the
circumstances—thus, the mandate is to be implemented
only “where appropriate” (FSB, 2010, p. 5). The G-20
Leaders’ Statement, however, does not provide any
guidance concerning when it is appropriate to require
trading on exchange or a similar trade execution plat-
form. According to the FSB, it may be appropriate to
mandate exchange trading:
... where the market is sufficiently developed
to make such trading practicable and where
such trading furthers the objectives set forth
by the G-20 Leaders and provides benefits in-
cremental to those provided by standardization,
central clearing and reporting of transactions
to trade repositories. (FSB, 2010, p. 5)
Ultimately, the decision is left to market regulators.
This traps regulators in complicated decisions about
infrastructure design that are not simply technical in
nature—as we noted earlier, they also have different
89
implications for different types of market users— FIGURE 4
potentially benefiting one group at the expense of Bilateral network
another (Harris, 2003; Madhavan, 2000). As we have
noted, there are unavoidable trade-offs among pre-trade
transparency, liquidity, and price discovery that must
be taken into account in the design of a trade execution
mechanism. The G-20 trade execution mandate favors
a centralized approach based on the assumption that
extensive pre-trade transparency is equally beneficial
to all market participants, an assumption that is not
supported by the market microstructure literature.
Moreover, all market participants, regardless of their
preferences concerning pre-trade transparency, will
be harmed if the implementation of the mandate im-
pairs liquidity, price discovery, and the ability to use
derivatives markets for hedging purposes.
Because the objective of improving market trans-
parency can be accomplished by other, less costly and
disruptive means, certain G-20 countries have indi- Notes: Red circles represent protection sellers; blue circles
cated that they will not implement, or will delay im- represent protection buyers. The size of each circle indicates the
relative amount of protection traded.
plementation of, the trade execution mandate, and some Source: Yellen (2013).
G-20 countries will not mandate but only encourage
central clearing through an incentive-based regulatory
framework.17 According to the FSB, progress in im-
to all trades accepted for clearing. In effect, the CCP
plementing the trade execution mandate remains “slower
becomes the buyer to every seller and the seller to
than in other commitment areas” and “[s]ome author-
every buyer and undertakes to perform in place of the
ities have indicated that they are waiting for useful data
original counterparties to such trades. Central coun-
to be available before adopting requirements to promote
terparty clearing thus transforms opaque bilateral coun-
increased exchange and electronic platform trading”
terparty credit relationships into a “hub and spoke”
(FSB, 2013, p. 27).
arrangement. As a result of central clearing, counterparty
Central counterparty clearing relationships become simpler and more transparent—
As we noted in our discussion of the “counterparty each clearing member has a single counterparty, the
credit risk externality” identified by Acharya and Bisin, CCP. Thus, “[h]igher-order, unobservable counterparty
traders in some markets may be dependent upon the credit risk is replaced by first-order, observable coun-
ability and willingness to perform of a party with whom terparty risk with respect to the CCP” (Gai, Haldane,
they did not deal directly and whose creditworthiness and Kapadia, 2011, p. 468).
they may not be able to evaluate. Figure 4, for example, Central clearing, however, does not completely
employs actual data to represent a point-in-time snap- eliminate opacity or interdependence. There are several
shot of the complex relationships among counterparties reasons for this. First, the CCP becomes the substituted
in a single credit default swap contract that is traded bi- counterparty only to transactions between clearing
laterally and not centrally cleared. members. End-users and non-clearing members typi-
The counterparty relationships in this illustration cally have no recourse against the CCP if a clearing
are necessarily opaque—only bilateral counterparties member intermediary fails to meet its obligations to
stand in direct contractual relationships and no single its customers (Scott, 2010; Jones and Pérignon, 2008;
market participant can have a complete view of all Jordan and Morgan, 1990). Moreover, these customers
relevant credit and liquidity relationships. In particular, ordinarily do not know the identities or risk exposures
market participants may not know their counterparties’ of the clearing member’s other customers. Nevertheless,
exposures to others, upon which they are indirectly they may be exposed to the risk of “fellow customer”
dependent. The lack of such information can result loss (depending on applicable law) if the default of
in an “information-related gridlock that we observed another customer causes the clearing member to default
in the fall of 2008” (Yellen, 2013, p. 14). on its obligations. These end-users remain dependent
In central clearing arrangements, a central coun- upon potentially complex, inherently opaque credit chains
terparty (CCP) becomes the substituted counterparty to which they are exposed indirectly through their

90 3Q/2014, Economic Perspectives

common intermediaries. Central clearing internalizes
some, but not all, externalities in the assessment of
counterparty credit risk.
In addition, CCPs depend on a variety of services
provided by financial intermediaries, such as settlement
banks, custodians, and liquidity providers. These ser-
vices and the arrangements among CCPs and their
critical service providers are far from simple or trans-
parent. For example, CCPs depend critically on daily
(and sometimes intraday) variation settlements—some-
times called variation margin. These payment flows
occur through the interbank payment system (or systems)
for each currency in which variation settlement obli-
gations are denominated. Not all CCP clearing members,
however, have direct access to those systems. Those
that do not must use settlement banks to make variation
settlement payments on their behalf. Settlement banks
intermediate settlement payments and may also provide
intraday credit to support the exchange of payments
between the CCP and its clearing members. Settlement
banks are typically among the largest clearing members
of a CCP. The failure of a bank that acts both as a clearing
member and a settlement intermediary would pose a
significant risk to a CCP.
Central clearing arrangements are designed to
mitigate counterparty credit risk. They do so by using
a number of important risk management tools—such
as netting, collateralization, and membership standards.
The use of these risk-management tools also makes
CCPs dependent on time-critical flows of liquidity. This
means that payments or transfers “must be made at a
particular location, in a particular currency (or securi-
ties issue), and in a precise time frame measured not
in days, but in hours or even minutes” (Marshall and
Steigerwald, 2013, p. 30).
An example of the risks posed by CCPs’ depen-
dence on time-critical liquidity flows intermediated
by settlement banks occurred in October 1987 when
global equity markets plunged and clearing members
were required to meet large intraday and end-of-day
margin calls. Settlement banks became “less willing
to advance credit to clearing members” and the Federal
Reserve had to take action to ensure adequacy of ag-
gregate liquidity in the financial system (Marshall and
Steigerwald, 2013, p. 41). The situation was further
complicated by the operational failure of the Federal
Reserve’s Fedwire funds transfer system on Tuesday,
October 20, 1987, as clearing members were attempt-
ing to meet their margin calls.
Central counterparty clearing can be effective in
managing counterparty credit risk. Does it also mitigate
systemic risk? As we have seen, it transforms counter-
party relationships by interposing the clearinghouse
Federal Reserve Bank of Chicago
as the common counterparty to all clearing members.
As a result, clearing members (and the end-users on
behalf of which they act) become completely dependent
on the ability of the CCP to perform its obligations (see
Murphy, 2013, and Duffie, Li, and Lubke, 2010). In
addition, central clearing concentrates risk in the CCP
making it “... a major channel through which ... [finan-
cial] shocks are transmitted across domestic and inter-
national financial markets” (CPSS–IOSCO, 2012, p. 5).
Masaaki Shirakawa (2012), a former governor
of the Bank of Japan, notes that central clearing has
“unambiguous advantages” (p. 3). Nevertheless, he
also notes that:
[C]entralized clearing has its own issues.
It may increase, if not properly designed,
moral hazard among market participants,
who will be less concerned with counterparty
risk. Centralized clearing also concentrates
risk in the clearing entity itself, which might
become “too big to fail.” (Shirakawa, 2012,
p. 3, emphasis added)
Whether the benefits of central counterparty
clearing dominate or whether they are substantially
offset by costs that are both pervasive and irreducible,
remains an open question.
It is important to note that although central clear-
ing with counterparty substitution provides the foun-
dation for modern futures and other financial markets,
its significance has not been widely appreciated by
policymakers or academics. Until recently, moreover,
academic interest in the institutional structure of deriv-
atives markets and the nature and significance of central
counterparty clearing has been limited.
Conclusion
In this primer, we discussed the trading and clearing
infrastructure for derivatives, as well as some impor-
tant policy changes that are shaping those structures.
In the first part of the primer, we provided a foundation
for understanding the economic role, selected risks,
and significance of derivatives markets. We explained
the value chain of a typical derivatives transaction,
starting with negotiation of the contract and ending
with final settlement, and briefly described the evolution
of derivatives markets. We also discussed the impact
of the G-20 market structure mandates and related
regulatory changes.
In response to the G-20 market structure mandates,
some OTC markets are converting to futures markets
(Weitzman, 2012). For example, a segment of the
energy OTC derivatives market has been “futurized” by
the conversion of swap contracts to swap futures con-
tracts (CFTC, 2013). Market participants may find it
91
possible to use standardized futures markets for hedging.
If not, some may decide to exit derivatives markets alto-
gether. It remains to be seen how these developments
will unfold. At a minimum, they suggest that the G-20
market structure mandates may result in important but
unintended consequences, such as the fragmentation
of the global OTC derivatives market (ISDA, 2014).
In the second part of the primer, we focused on
the policy rationale for the G-20 trade execution and
central clearing mandates. We noted that centralized
trade execution and central counterparty clearing
have many benefits, but also may involve significant
costs. The central question for policymakers is
whether the benefits of executing derivatives trades
on exchanges, through SEFs or similar trading facili-
ties, and clearing transactions through CCPs out-
weigh the costs associated with the mandates.
Efforts to provide a comprehensive economic
analysis of the G-20 reform program for OTC derivatives
have recently begun. For example, the Macroeconomic
92
Assessment Group on Derivatives (MAGD) issued an
assessment of the G-20 reforms in August 2013 (BIS,
MAGD, 2013). MAGD, which included representatives
of member institutions of the FSB working in collab-
oration with the International Monetary Fund, studied
selected aspects of the G-20 reform program for OTC
derivatives18 and concluded that “the economic benefits
of [the] reforms are likely to exceed their costs” (BIS,
MAGD, 2013, p. 3).19 However, the MAGD chairman
also points out that more work is needed to improve
our understanding of the likely macroeconomic impact
of regulatory reforms that target the derivatives as well
as other types of financial contracts (Cecchetti, 2013,
p. 8). The work of MAGD is, on balance, a positive
development. We should not, however, underestimate
the challenge of fairly assessing the costs and benefits
of the G-20 program of regulatory reforms for deriva-
tives markets. We look forward to further studies of
the type undertaken by MAGD and eagerly await the
results of those studies.
3Q/2014, Economic Perspectives
NOTES
See Smyth and Wetherilt (2011, p. 334): Trade execution arrange-
1 13
ments are constantly evolving and can be quite complex.
2
See Group of Twenty (2009, p. 9). We refer in this article to the
trade execution and central clearing mandates as “market structure”
mandates.
3
The capital and trade reporting requirements are important. However,
a thorough analysis of these requirements is outside the scope of
this article.
4
The Financial Stability Board coordinates the work of national
financial authorities and international standard-setting bodies to
foster global financial stability through the development and implemen-
tation of effective regulatory, supervisory, and other financial policies.
More details and a list of institutions represented are available at
www.financialstabilityboard.org/about/overview.htm.
5
This discussion is intended as a description of economic attributes,
not legal and regulatory characteristics.
6
We exclude from our discussion employee stock options, which
are a form of contingent compensation, not risk transference
(derivative) contracts.
7
For statistical purposes, the BIS treats any derivatives contract
with an embedded option as an OTC option and reports such contracts
separately from OTC forwards and swaps.
8
Market makers are a good example—they aim to have a hedged
portfolio, but also provide liquidity to the market through speculation.
For further details, see Heckinger et al. (2014).
9
See, for example, DTCC (2014). We do not consider margining
arrangements for derivatives markets in detail in this primer. For
additional information, see ISDA–CSC (2010) and Johnson (2007).
10
When one or more reference entities in a CDS index fails to
perform its contractual obligations, the ISDA Credit Derivatives
Determinations Committee may declare a credit event—triggering
payment to protection buyers. Following a credit event, the CDS
index would be revised to replace the defaulting reference entity.
11
The U.S. Commodity Futures Trading Commission (CFTC, 2013)
defines an SEF as a “trading system or platform in which multiple
participants have the ability to execute or trade swaps by accepting
bids and offers made by multiple participants in the facility or system,
through any means of interstate commerce, including any trading
facility, that (A) facilitates the execution of swaps between persons;
and (B) is not a designated contract market” (pp. 33476–33481).
See Giancarlo (2014), available at www.cftc.gov/PressRoom/
12
SpeechesTestimony/opagiancarlos-1.
Federal Reserve Bank of Chicago
ISDA claims that its empirical analysis of cleared derivatives data
provides evidence that implementation of the SEF trading requirement
in the U.S. has caused fragmentation between U.S. and European
markets. See, for example, http://www2.isda.org/functional-
areas/research/research-notes/.
The discussion in this section is based primarily on Harris (2003),
14
Hasbrouck (2007), and Duffie (2012).
15
As Duffie (2012) also notes, however, “[s]ome OTC markets have
special intermediaries known as brokers that assist in negotiations
between buyers and sellers, conveying the terms of one investor to
another, usually without revealing the identities of the counter-parties
to each other” (p. 1). Consequently, some OTC markets may not be
pure dealer markets. For a discussion of interdealer trading in OTC
markets, see Hasbrouck (2007).
16
For example, Hasbrouck (2007) notes that “[a] dealer may make
continuous trading possible when the natural customer-supplied
liquidity in the book would not suffice” (Hasbrouck, 2007, p. 16,
emphasis added).
Most member jurisdictions plan to implement the central clearing
17
commitment through a combination of mandatory clearing requirements
and incentives, such as higher capital and margin requirements.
Several jurisdictions indicated that, at least initially, they anticipate
implementing the commitment to centrally clearing all standardized
OTC derivatives through incentives alone (FSB, 2013).
MAGD explains that it examined the following direct costs to
18
market participants as a result of the G-20 reforms:
(i) the cost of increased collateral required by CCPs and
by bilateral margining rules; (ii) the cost of increased reg-
ulatory capital required by Basel III; and (iii) other direct
costs of reform. The sum of these costs, when compared
to the pre-reform costs of trading OTC derivatives, gives
an estimate of the extra costs of using OTC derivatives
once reforms have been fully implemented. We estimate
the change in annual global costs as between €15 billion
and €32 billion, with a central estimate of €20 billion
(table 10) (BIS, MAGD, 2013, p. 37).
MAGD also notes that its estimates were not intended to be
comprehensive.
19
Addressing only the clearing mandate, Milne (2012, p. 1) argues
that the costs of the mandate “are not so large as some commentary
has suggested, at least provided that mandatory clearing is applied
only to widely traded standardized contracts.”
93
APPENDIX A: EXAMPLE OF A FORWARD CONTRACT

Company USA enters into a contract with Company Italy
to purchase 650,000 square feet of 9 cm. thick-honed
Italian Carrara Bianco marble slabs for €1 million to be
delivered in three months on September 30, XXXX. The
terms of the contract stipulate the payment in full (in euros)
at the time of delivery. Company USA will need to con-
vert U.S. dollars to euros to meet its settlement obligation.
To mitigate the exchange rate risk exposure, Company
USA enters into a forward contract to lock in an exchange
rate of 1 euro = 1.30 U.S. dollars.
Parties to the forward contract are exposed to the
counterparty risk:
a. Company USA enters into a forward contract
with a bank. The bank fails. Company Italy delivers
the marble and Company USA needs to pay euros
to Company Italy. Company USA exchanges
U.S. dollars for euros at the prevailing exchange
rate. Company USA would incur a loss if the
U.S. dollar depreciated against the euro.
b. Company USA enters into a forward contract
with a bank. The bank delivers euros as agreed,
but Company Italy is bankrupt and fails to de-
liver the marble. Company USA can “close out”
the FX forward or exchange euros back to U.S.
dollars at the prevailing exchange rate. Company
USA would incur a loss if the U.S. dollar appre-
ciated against the euro.
c. Company USA enters into a forward contract
with Company Italy. Company Italy is bankrupt,
fails to deliver the marble, and also defaults on
the forward currency contract. Company USA
has no exchange rate risk exposure (but, of course,
may suffer a loss replacing the undelivered marble).

Pays fixed 5%

BANK BANK
A B
Pays floating 3-month LIBOR

3-month
Payment Fixed Fixed LIBOR Floating
PMT # Reset date date rate payment rate payment Net cash flow
(percent) (dollars) (percent) (dollars) (dollars)

1 1/1/XXXX 4/1/XXXX 5.000 125,000.00 4.302 107,550.00 17,450.00 Fixed (Bank A) pays
2 4/1/XXXX 7/1/XXXX 5.000 125,000.00 4.403 110,075.00 14,925.00 Fixed (Bank A) pays
3 7/1/XXXX 10/1/XXXX 5.000 125,000.00 4.745 118,625.00 6,375.00 Fixed (Bank A) pays
4 10/1/XXXX 1/1/XXXX+1 5.000 125,000.00 4.872 121,800.00 3,200.00 Fixed (Bank A) pays
5 1/1/XXXX+1 4/1/XXXX+1 5.000 125,000.00 5.581 139,525.00 (14,525.00) Floating (Bank B) pays
6 4/1/XXXX+1 7/1/XXXX+1 5.000 125,000.00 5.468 136,700.00 (11,700.00) Floating (Bank B) pays
7 7/1/XXXX+1 10/1/XXXX+1 5.000 125,000.00 5.460 136,500.00 (11,500.00) Floating (Bank B) pays
8 10/1/XXXX+1 1/1/XXXX+2 5.000 125,000.00 5.058 126,450.00 (1,450.00) Floating (Bank B) pays
Total 1,000,000.00 997,225.00 2,775.00

94 3Q/2014, Economic Perspectives

APPENDIX B: EXAMPLE OF A FUTURES CONTRACT
On September 16, XXXX, Company A, a speculator ex-
pecting the price of oil to increase, purchases 100 November
XXXX crude oil futures contracts based on a benchmark
grade (West Texas Intermediate or WTI) on the Inter-
continentalExchange (ICE) at $91.62 per barrel. Let’s
say that on September 19 the market has moved and the
price per barrel is now $94 and Company A decides to
capture the profit by selling 100 contracts at the market
APPENDIX C: EXAMPLE OF A BILATERAL SWAP CONTRACT
Bank A and Bank B enter into a two-year plain vanilla,
fixed for floating interest rate swap (IRS) on 1/1/XXXX
on a notional amount of $10 million. The fixed rate is set
at 5 percent and floating at three-month London Interbank
Offered Rate (LIBOR).
In this example, there are eight quarterly payments.
Reset date refers to the date on which a new floating rate
becomes effective for the period—in this case, the period
is three months. Payment date refers to the date when
the cash flows are netted and payment received by one
counterparty.
Fixed rate refers to the fixed rate outlined in the swap
contract. The fixed payment is calculated by multiplying
the notional amount by the interest rate divided by the
number of periods in one year (in this case = 4, 4 quarters
in a year).
Federal Reserve Bank of Chicago
price. (In the example we do not include any transaction
costs, commissions, fees, the cost of margins, or the time
value of money.)
Each WTI contract listed on ICE is for 1,000 barrels
of crude oil.
Profit = 100 (contracts) * ($94  – $91.62) * 1,000 (barrels) =
= 100* $2.38 * 1,000 = $238,000.
Floating rate refers to the prevailing floating rate as
specified in the contract (in this case three-month LIBOR
rate) as of the reset date (in this example the LIBOR rate
is hypothetical). The floating payment is calculated by
multiplying the notional amount by the floating interest
rate divided by the number of periods in one year. Cash
flows are calculated by subtracting the floating payment
from the fixed payment amount. The amounts in red de-
note that the counterparty with a floating obligation pays.
95
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